Master Thesis
Initial Coin Offerings – An Exploratory Analysis
by Fatih Demirciler 11400897 August 2018 Supervisor: Dr. J.K. Martin
Table of Contents
Introduction ... 1
Description and Explanation of Initial Coin Offering Mechanism ... 5
2.1 Definition of Initial Coin Offering ... 5
2.2 How an Initial Coin Offering Works... 7
2.3 Token Sale Models and Token Characteristics ... 10
2.3.1 Token Sale Models ... 10
2.3.2 Tokens Types ... 12
2.4 Comparison of ICOs with Other Types of Fundraising Mechanisms ... 14
2.5 Regulatory Approach in Different Jurisdictions ... 21
2.6 Growth in ICO Market ... 25
2.7 Risks and Challenges in ICO Mechanism ... 27
Data Collection Methodology ... 31
Analysis of the Dataset ... 33
4.1 Jurisdiction ... 33
4.2 Sector ... 34
4.3 Management Team ... 35
4.4 Token Distribution Model ... 36
4.5 Token Discount Schedule ... 36
4.6 Hardcap ... 37
4.7 Return on Investment since Offering ... 37
Conclusion ... 39
Abstract
An initial coin offering (ICO), also known as a token sale, is a mechanism in which an organization sells digital tokens to raise capital to fund software development, business platform or other projects. ICOs have become an alternative way of fundraising for growing number of entrepreneurial initiatives. In this paper, I made an extensive analysis on ICO structure and its dynamics as well as its comparison with other fundraising mechanisms. Furthermore, by reviewing the 50 biggest coin offerings by funds raised between 2014 and 2017, I provided an exploratory analysis for ICOs in order to reveal their common characteristics. My analysis has significant findings. It helps the investors assess the projects’ business plans extensively. My findings also help the regulators set a regulatory framework that offers an entrepreneurial environment but also imposes clear rules for investor protection.
Introduction
Almost every new entrepreneurial initiative requires funding to realize what it promises (Gompers and Lerner, 2004). After the bitcoin technology was first proposed in 2008 (Nakamoto, 2008), new ventures based on blockchain and cryptocurrencies were dramatically increased. While the world has become more and more connected, new forms of transactions have emerged. Along with growing popularity of bitcoin and blockchain technology, digital currencies have tokenized and decentralized the money and led to a potential disruption in financial industries (Larios-Hernández, 2017). Therefore, raising capital through coin offerings have become a major source of funding for new ventures. New network structures have offered blockchain based ventures a fertile ground to grow. Especially, Ethereum’s peer-to-peer network structure (Buterin, 2014) have helped new initiatives to grow on blockchain technology.
An initial coin offering (ICO), also known as a token sale, is a mechanism in which an organization sells digital tokens to raise capital to fund software development, business platform or other projects. A token is a cryptographic equivalent to shares to represent a set of rights. Therefore, it’s a digital medium of value which is used in blockchain based transactions (Hill, 2017). Depending on the structure of the token, this could be an access right to use a network or software application, or in some cases, the right to receive a share of future earnings. In contrast to a regular IPO, ICOs do not generally offer voting rights by owning the tokens.
ICOs have become an alternative way of fundraising for growing number of entrepreneurial initiatives. Due to their nature of services, ICOs generally differ from each
other. Before the actual token sale, initiatives issue their whitepapers, an equivalent to prospectus in IPOs, which describes their business plans and also the technical details of the token. These informative documents, whitepapers, normally include information about the team behind the project, which technology is used, and how the proceeds from the token sale will be used during the project. In this respect, whitepapers seem to be the only source of information for the investors to assess the related ICO.
Token sale can be done in exchange for Fiat currencies (i.e. EUR or USD) or cryptocurrencies (i.e. BTC or ETH). Buyers receive some number of the project’s native tokens. In a public sale, any investor can participate to the offering. This is clearly in contrast to IPO process. In a regular IPO process, initial offering is made to institutional investors. In some rare cases, individual investors are invited to initial offering. Buyers may participate to the offering for different purposes. Some of the buyers’ main interest is to use services provided by the platform or software. Some of the buyers aim generating profit from trading of these tokens. Most of the ICOs market their tokens before the regular date of offering. In this way, tokens are sold with a discount in order to attract more buyers and to increase the utilization rate of the offering. Unlike a regular IPO which takes around more than six months to prepare before going public due to strict regulation, a typical ICO process takes place between one and three months.
Since ICOs are completely new kind of mechanism to raise funding, its theoretical and practical framework are continuously changing. This behavior brings many opportunities and also challenges. While its decentralized structure and easy to join for the investors help decrease the cost of fund raising (Kaal, 2018) and transaction cost (Kaal, 2017). Unlike
legal, investor rights and tax perspectives (Zetzsche, Buckley, Ross, Arner, Föhr, 2018). In addition, each jurisdiction has different treatments against ICOs (Kaal, 2018).
Starting from Mastercoin’s ICO in July 2013, both size and number of ICOs continuously increased (Shin, 2017). According to CoinDesk (www.coindesk.com) which is one of the well-established cryptocurrency and ICO information website, number of ICOs have reached to 400 and collected USD 5.8 bn worth of cryptocurrency or fiat currency.
2014 2015 2016 2017 Total
Funding (million USD) 30 9 256 5,482 5,777
Number of ICOs 7 7 43 343 400
Table 1.1 – Number of ICOs and amount raised1
Considering the dollar size that is raised, ICOs have clearly surpassed other kind of crowdfunding or venture capital funding mechanisms. In Kickstarter2, one of the biggest crowdfunding platform, around 150,000 projects have raised approximately USD 3.8 bn since 2009.3 In addition, based on Ernst and Young report4, ICOs have also surpassed venture capital (VC) funding in 2017.
1 https://www.coindesk.com/ico-tracker 2 www.kickstarter.com 3 https://www.kickstarter.com/help/stats 4 https://www.ey.com/Publication/vwLUAssets/ey-research-initial-coin-offerings-icos/$File/ey-research-initial-coin-offerings-icos.pdf
Figure 1.1 – Cumulative ICO and VC Funding
ICOs have recently become a major topic due to size of the funds raised with these projects. While its disruptive nature in transforming both conventional and new businesses is generally acknowledged, lack of information on the projects poses a threat for the investors during investment decisions. In this paper, my aim is to bring more visibility to this new kind of funding platform. Therefore, I conduct a detailed analysis of ICO mechanism. Second section elaborates how a typical ICO process work, what are the key steps in this process and who are the parties involved. In the third section, I elaborate the data collection methodology, data sources, what kind of information is collected. Fourth section shows an exploratory analysis by using the information I obtain from the whitepapers and other sources. I analyzed the 50 biggest ICOs between 2014 and 2017 based on CoinDesk database. In this analysis, I perform exploratory analysis on my dataset in order to reveal
different dimensions of ICOs. These dimensions are the jurisdiction where the venture as an incorporation is registered, industry or sector that the venture is operating, roadmap on how to use the proceedings from token sale, ICO management information, guideline on token distribution, any discount schedule if an early token sale is conducted, any limit on token creation (hardcap) and return on investment since offering. Last section contains my conclusion on my exploratory analysis.
Description and Explanation of Initial Coin Offering
Mechanism
2.1 Definition of Initial Coin Offering
Initial coin offerings are conducted in several different ways. Therefore, it’s not easy to describe ICOs in a single definition. In a broad way, an initial coin offering (ICO), also known as a token sale, is a mechanism in which an organization sells digital tokens to raise capital to fund software development, business platform or other projects. A token is a cryptographic equivalent to shares to represent a set of rights. Therefore, it’s a digital medium of value which is used in blockchain based transactions (Hill, 2017). Depending on the structure of the token, this could be an access right to use a network or software application, or in some cases, the right to receive a share of future earnings. In contrast to a regular IPO, ICOs do not generally offer voting rights by owning the tokens.
Since coin offerings aim to build products and services based on blockchain technology, it’s required to define this technology. A blockchain is a distributed ledger where each transaction on the network is registered. This network is managed by a peer-to-peer network which means each member of the network has the ability to register transactions
considering that they conform the network’s technical requirements (Buterin, 2014, Nakamoto, 2008). All the transactions are attached together as blocks in this distributed ledger. Transactions in the ledger are recorded after they are validated by the network itself. This validation is a result of consensus within the network. Therefore, transactions do not need any approval authority. In this way, blockchain eliminates the need of trust for a central authority (Nakamoto, 2008). Due to its nature, all the transactions are visible to everyone and they can be easily tracked. Thanks to its revolutionary approach, blockchain has offered a platform where the new ventures had the ability to utilize their vision. When Ethereum network offered a fast and more productive platform, developers took this advantage to produce innovative applications offering decentralized services and tokens in order to use these services. Tokenizing any service has opened vast possibilities of disruptive entrepreneurship. In this respect, a token is a cryptographically secured digital representation of a set of rights. Depending on the token, this could include the right to access and use a network, application or a service. Therefore, the main purpose of a token offering is to provide funding to the ventures in order to develop blockchain-based products and services.
Almost every new entrepreneurial initiative requires funding to realize what it promises (Gompers and Lerner, 2004). When the ventures realized the importance of tokenizing the products and services that they offer, initial coin offering has emerged as an alternative way to raise funding. While initial coin offerings offer a great deal of efficiency to raise capital for early investment, growing interest from crypto investors provides easy access to liquidity. This situation helps the ventures overcome fundraising challenges in their early stage investments. In addition, ICOs give the opportunity to the blockchain-based ventures
to raise funding and avoiding conventional fundraising channels such as initial public offering (IPO) and venture capital. Due to this reason, ICOs have become a major source of funding for blockchain-based ventures in recent years. During 2017, funds raised from ICOs have surpassed venture capital funding (see Figure 1.1).
2.2 How an Initial Coin Offering Works
Although ICOs have become a recent phenomenon, some form of common practice has been developed during ICO process5. Therefore, a typical ICO has certain structural elements and phases. These elements and phases can be elaborated by respecting their order in ICO timeline:
1. Idea: An entrepreneur or group of entrepreneurs has an idea for product or service that is going to run on a decentralized network such as Ethereum platform. This entrepreneurial group drafts their idea as a project.
2. Team Building and Research: The project starts recruiting team members and necessary advisors based on the need of the project. The project team works on the important aspects of the project. They need to decide what kind of technology that their product or service is going to be running. They clarify the business plan for the market, target customers, pricing, structure of the token sale and administrative process.
3. First Announcement: The project is announced on social media and related cryptocurrency forums such as Bitcoin Talk, Cryptocointalk and Reddit.
5 R. Aitken, in Investment Guide To “Crypto”Coin Offerings Ratings Blockchain Startups (January 6, 2017),
Forbes, available at https://www.forbes.com/sites/rogeraitken/2017/01/06/investment-guide-to-crypto-coin-offerings-rating-blockchainstartups/#614e6940121b
4. Publishing Whitepaper: Comments from the forums are taken into consideration during finalizing the draft technical and business plan. Whitepaper is a document providing detailed technical information about the technology used in the project, phases of the project, investment strategy, token distribution schedule, early token sale discount schedule (if any), information about the project team. However, whitepapers are not standardized documents, unlike IPO prospectus. Therefore, it may differ for each project. Since whitepaper is the only source for the investor to obtain information about the project, it’s important to provide clear and detailed information in the whitepaper.
5. Marketing: The project team introduces the project to selected number of people such as early investors, industry insiders and technology advisors. In this step, the team does improvements in their project based on the comments received. 6. Legal Counseling: Project team seek legal counseling about corporate structure,
tax, jurisdictional concerns for money transfers and the like. This counseling also helps the team on which country (jurisdiction) they want to register their incorporation.
7. Pre-Sale: Some projects can offer tokens before their official ICO. In this phase, they offer tokens with a discount in order to encourage early investor. Their aim with the pre-sale is generally cover legal, operational and development costs. 8. Marketing Push: The team starts a major marketing campaign in order to become
more visible to the general audience. They promote the project on major channels such as Google ads, Facebook, Twitter, Telegram, Reddit.
9. Sale Begins: Initial coin offering officially starts. The sale is conducted based on the dates either published on the whitepaper or the project’s website. Token sale is generally done with another major cryptocurrency such as Bitcoin or Ethereum. In most of ICOs, the proceedings are stored in a multi-signature public wallet6.
10. Build the Project: When the sale is ended, the team liquidates some of the proceedings in order to build the project.
11. Product Launch: The product or service is completed, and token holders can use it.
Unlike IPO process which takes generally more than 6 months, ICOs are finalized 1-3 months in average.
Figure 2.1 – High Level Timeline for a Typical ICO7
6 Kalla, What is a Token Sale (ICO)?, Smith & Crown, 21 June 2016,
https://www.smithandcrown.com/what-is-an-ico/ (last accessed 02.07.2018).
7 “ICO Best practices”, Pricewaterhousecoopers, 2017,
2.3 Token Sale Models and Token Characteristics
An initial coin offering offers an alternative way of raising funding for blockchain-based ventures (Jackson, 2017). It also offers an opportunity to the investors to be early stakeholders in financing disruptive products and services (Massey, 2017). Entrepreneurs traditionally raise funds by either going public (IPO) or trying to find funding from angel investors or venture capitalists. During this process, entrepreneurs usually have to deal with many challenges. In this respect, ICOs emerged as a revolutionary way of fund raising. Entrepreneurs are now able to reach any investor who is willing to participate in their project. As it happens in crowdfunding, anyone with internet access can easily participate ICOs (Belleflamme et al., 2014). In line with its extraordinary approach in raising funds, different kind of token sale mechanisms were evolved. Ventures decide what kind of token sale mechanism is used based on their project needs and requirements. Therefore, token sale practices may vary for each ICO. Some projects chose auction mechanism so that the price is set by the demand of the investors participating to ICO. Some other projects set a fixed price during ICO. Hence, ICOs have been evolving and offering different sale mechanisms.
2.3.1 Token Sale Models
a. Uncapped Sales: In this type of sale, there is no token limit so that the project tries to sell as much token as possible during the sale period. It was heavily used by the early blockchain-based ventures during 2014 and 2016. This kind of sale has been criticized and it was seen a sign of “greed” for the project owners. Vitalik Buterin, creator of Ethereum platform, stated that major issue with the
uncapped sales is the higher uncertainty about the valuation of the tokens from the investor perspective (Buterin, 2017).
b. Capped Sales: After growing criticism about uncapped sale mechanism, most ICOs implement a limit for the tokens offered. This limit is often called “Hardcap”. This type of sale mechanism has become popular during 2016 and 2017. Vitalik Buterin emphasized, “capped sales have the property that it is very likely that interest is oversubscribed, and so there is a large incentive to getting in first” (Buterin, 2017).
c. Hybrid Capped Sales: This type of sale has emerged to make capped sales more flexible. In this sale mechanism, the project sets an initial cap which is called “Softcap”. When softcap is reached, the project extends the auction for a short period of time. Sale is finished when the previously hardcap is reached. Misterium8, decentralized marketplace for VPN services built on the Ethereum blockchain, has defined CHF 6 million softcap and CHF 14 million hardcap. When the softcap was reached, there was an additional 72 hours extension to the action. Even if the demand exceeds hardcap, it’s not possible to sell more than the hardcap9.
d. Fixed exchange rate: Tokens are sold with a fixed exchange rate against a cryptocurrency such as Bitcoin or Ethereum. It’s also possible to buy tokens with a Fiat currency for a fixed exchange rate. Tezos10, blockchain
8 https://mysterium.network
9 https://bitcointalk.org/index.php?topic=1932970.0 10 https://tezos.com/
infrastructure developer, offered 5,000 tezzies, name of Tezos network token, for one Bitcoin11.
e. Dutch Auction: In this type of sale, investors make their price offer and the quantity that they want to buy. After collecting all the offers, they are sorted from the highest to lowest price. All the offers above the token limit are accepted. All the offers buy the token from the price of the lowest accepted bid. Gnosis12, venture building market-driven forecasting technology, has sold its tokens with Dutch auction and raised more than USD 300 million in less than an hour13.
2.3.2 Tokens Types
Each project offers different kind of tokens, based on the project’s needs and vision. However, all tokens are the digital mediums of value exchange that work on the blockchain technology. Hence, they are called cryptocurrency. Bitcoin has become the most popular cryptocurrency after it was proposed in 2008 (Nakamoto, 2008). Most of the tokens that are offered in ICOs are traded against other cryptocurrencies, mostly Bitcoin and Ethereum.
Most tokens have intrinsic utility and offers various underlying rights (Hill, 2017). A token can function one or more utility characteristics (Russo and Kharif, 2017). As a result of growing ICO offerings, 5 main types of token have evolved:
11 https://bitcointalk.org/index.php?topic=2000227.0 12 https://gnosis.pm/
a. Usage Tokens: Usage tokens can be used to have access to the product or service provided by the project. They can be also called as “gift cards” or “licences”. Filecoin, a decentralized network for storing information, can be accessed by using the coin Filecoin. A user buys Filecoin token in order to pay for the miner so that they could store its data in exchange.14
b. Equity Tokens: This type of tokens offer the token holder an equity-like rights such as profit sharing or voting. Blockchain Capital (BCAP) tokens represent an indirect, fractional, non-voting economic interest in a venture capital fund called Blockchain Capital III, Digital Liquid Venture Fund, LP.15
c. Work Tokens: These tokens offer the token holder the chance to participate a work or project of an organization and earn revenue in exchange. Augur16 REP token holders who accomplish some certain tasks within the network can earn certain portion from Augur’s market fees.17
d. Community Tokens: This type of tokens is used to be able to access the functions of the network. Steem18 is a social content publishing platform in which STEEM tokens which are also called as “smart media tokens” are used to upvote user contributed content on the Steem website. The author of the content receives the tokens and can trade them on an exchange.19
e. Asset Tokens: These tokens are normally backed by a real-life asset. Each Ether’s token (USDT) can claim on one US Dollar which is held by Ether
14 www.filecoin.io 15 http://blockchaincapital.tokenhub.com/ 16 https://www.augur.net 17 https://www.reddit.com/r/Augur 18 https://steem.io 19 https://smt.steem.io
organization in its reserves. USDT tokens can be converted to real US Dollar in Ether platform.20
2.4 Comparison of ICOs with Other Types of Fundraising Mechanisms
ICOs offer entrepreneurs a new way of raising funds. Entrepreneurs can obtain funds with ICO to build the products and services based on blockchain technology can be utilised. This funding is normally raised by selling tokens of the related project in exchange of future rights of the products and services that the project promises so that project owners have the financial sources to initiate their project. In terms of fundraising, ICOs have similarities and differences with the other types of fundraising such as crowdfunding, venture capital and IPOs. In this section, each type of fundraising is explained and the similarities and differences with ICOs are elaborated.
Crowdfunding has recently become a popular type of fundraising. Crowdfunding can be defined as an alternative way of fundraising where entrepreneurs obtain funding from anyone who can contribute to the project via a dedicated crowdfunding platform such as Kickstarter, Indiegogo, and Gofundme. Crowdfunding projects may vary from individual projects to big and complex projects (Mollick, 2014). Anyone who wants to fund the project can participate in the crowdfunding. In this respect, crowdfunding has comparatively large investor base as it also happens in ICOs. In Kickstarter, one of the biggest crowdfunding platform, around 150,000 projects have raised approximately USD 3.8 bn since 2009. On the other hand, ICO projects have raised around USD 5.5 bn only in 2017 (see Table 1.1). Therefore, most of the crowdfunding projects have lower funding
needs compared to IPOs and ICOs. Therefore, average funding contribution in crowdfunding is relatively lower (Beaulieu et al., 2015). Since there is no need for a financial intermediary mechanism during fundraising, both ICOs and crowdfunding have very low transaction costs (Tapscott, 2017). There is also another similarity in sharing the rights of the project. Both mechanisms offer “the right to use” or “the right to own” of products and services they promise. This type of handing over the rights is often called “pre-selling”. In this way, investors participating in either an ICO or crowdfunding project pay in advance for the promised product and service in order for the project to realize the project.
Venture capital is another type of fundraising mechanism which can be regarded like ICOs. Venture capital mainly funds the ventures in their early stage (Gompers, 2004). The main motivation of investing in the ventures with high growth potential is to receive positive return when the venture becomes successful. In this respect, venture capital plays an important role for the entrepreneurs who is unable to raise funding in conventional ways such as borrowing or going public. Therefore, venture capital works as a seed fund in order to help the venture to realize its business plan. This support includes meeting financial needs in order to build production or research and development facilities, set up marketing, promotion and advertising activities. In addition, venture capital also works as a consulting institution and provides the venture with its expertise in managing the business. Hence, venture capital is often called as smart capital. Since the venture capital invests in the ventures in their very early stage, this represents a very high-risk profile for this kind of investment (Gompers, 1995).
In terms of providing capital to the venture in its early stage, venture capital is like ICOs. However, there is obviously difference in the rights they seek in return. Venture capital owns particular portion of the venture’s equity. In this way, it aims to generate positive return when the venture becomes profitable. On the other hand, ICOs usually offer the right to use the products or services in the future. Investor profile of these fundraising mechanism is also different. Venture capital raises capital from other investors such as banks, insurance firms or pension funds and invests in high risk-return ventures. Hence it plays an intermediary role between the capital providers (i.e. banks, pension funds) and capital seekers, in this case the ventures (Sahlman, 1990). In contrast, ICOs offer a mechanism without any intermediary. Capital providers (token holders) and the venture (project owners) interact directly.
In terms of regulation and monitoring, there are also important differences between these two fundraising mechanisms. Venture capital firms are under close supervision by the regulators such as SEC based on Securities Exchange Act of 1934 and the Investment Company Act of 1940. In addition, they are also closely monitored by the capital providers (i.e. banks, pension funds). On the other hand, there is no regulation or law which regulate ICO activities21. Therefore, ICO investors (token holders) do not have any particular regulatory protection as of August 2018.
In terms of risk-return profile, these two fundraising mechanisms certainly has similarities. Both mechanisms have quite high failure rates which might be considered expected as they aim to invest in the ventures in their early stages where the chance of becoming successful
https://www.sec.gov/news/public-is rather low. Failure rate for the venture capital was calculated around 90% during the 90’s (Timmons et al., 1994). Recent study conducted by Cambridge Associates, an investment firm, shows failure rate is around 60%22. Similarly, 59% of the ICOs that took place in 2017 has already failed23. Hence, risk of failure is already high in these types of fundraising mechanism as it is illustrated in Figure 2.2 (Lipusch, 2018).
Figure 2.2 – Risk Profiles of Different Fundraising Mechanisms
Initial Public Offering (IPO) has been one of the most fundamental way of fundraising for firms. IPO is a mechanism in which firms raise funding in exchange for their equity through a public offering. Any kind of investor can participate in the public offering. Investors receive dividend payments from the firm or seek positive returns from the appreciation of the shares (Schneider et al, 1981). In addition, the investors have the voting rights as long as they obtain necessary number of shares. The firms usually go public after they reach a
22 http://fortune.com/2017/06/27/startup-advice-data-failure/ 23 https://news.bitcoin.com/46-last-years-icos-failed-already/
certain level of maturity in their business. Therefore, through IPO they raise funding in order to expand their business.
IPO is strictly regulated fundraising mechanism. Each jurisdiction sets rules and standards for IPO process. Therefore, there are many intermediaries such as investment banks, underwriters involved during the process. Due to this intermediation activities, IPOs are costlier than ICOs. Comparison in intermediation and transactions costs for each of the fundraising mechanisms are illustrated in Figure 2.3 (Lipusch, 2018).
Figure 2.3 – Intermediation and Transaction Costs of Different Fundraising Mechanisms
IPO duration is also very long than ICOs due to regulatory requirements such as preparing prospectus which is similar to whitepapers in ICO, complying with the financial reporting requirements. In this matter, investors participating IPOs have more information about the firm thanks to prospectus and other sources which are dictated by the regulator to the firm. This is clearly an important step in decreasing information asymmetry between the investor and the firm. Since there are no regulatory constraints for ICO process, investors usually
information about the venture while ICO occurs in the project phase. Due to strict regulatory constraints, a typical IPO process is completed in at least 6 months to 3 years24. On the other hand, an ICO process ends in between 1 and 3 months in average. Another important difference between IPO and ICO is related to timing of the fundraising through the life cycle of the ventures. Later stage firms that already establish their business and seeking growth capital choose IPOs. In contrast, early stage ventures that has an idea or a project but no track record of the business choose ICOs.
24 EY Guide to Going Public, EY, 2013
ICO IPO Venture Capital Crowdfunding
Life Cycle Early Stage Later Stage Early Stage Early Stage
Asset Type Token Shares Shares Ownership of a product or service
Underlying Rights Various but mostly right to use product or service only, no ownership or voting rights in the venture incorporation
Shares that give dividend and the right to vote
Shares that give dividend and the right to vote
Only the right to own the product or use the service
Venture Type Blockchain-based internet ventures Any venture with a track record already operating in an industry
Ventures with promising projects (biotechnology, nanotechnology, software, renewables, etc.)
Any kind of individual or group projects promising a product or service
Investor Type Any investor who believes in disruptive effects of the technology the venture promises and any investor seeking positive return from potential value increase of the token
Institutional and individual investors
Institutional investors Any investor supporting the project
Legal & Regulatory Aspect
No regulation dedicated to ICO Complex and strictly regulated
Highly regulated No regulation dedicated to crowdfunding
Liquidity Centralized & decentralized cryptocurrency exchanges
Securities exchanges Selling shares directly to another investor
No exchange. Transaction between only project owner and crowdfundee.
2.5 Regulatory Approach in Different Jurisdictions
ICOs have brought an efficient way of raising funds with minimum transaction costs. Therefore, the ventures are able to reach the funding in an easy and fast way. At the same time, investor base has been increased very much. ICOs provides an adequate mechanism for the ventures in order to minimize the funding gap by connecting them with a large group of investors (Mollick, 2016).
Despite its disruptive effects in connecting fund seekers (the ventures) and fund providers (investors), lack of standardization in ICO process and regulatory supervision, ICOs can result in undesired outcomes from the investors’ perspective. As almost all the ICOs offer only the right to use a product or service in the future, current regulations may not cover the token holders in case of any dispute. Therefore, there are still many issues to be clarified so that ICOs can gain ground to become a reliable and sustainable funding mechanism. In this section, regulatory perspective of major jurisdictions for ICOs is examined.
a. United States: Although each state in the United States has different approach towards cryptocurrencies, on July 19, 2017, the Uniform Law Commission approved the Uniform Regulation of Virtual Currency Business Act to be used as a model law for states seeking to adopt regulations for virtual currency businesses. The goal of the act is to create a harmonized regulatory schema for all 50 states and have reciprocity amongst states for virtual currency business licenses. Financial regulators have had a “do not harm” policy by respecting the disruptive and revolutionary aspects of blockchain technology. U.S. Commodity Futures Trading Commission (CFTC) Chairman Christopher Giancarlo stated
that blockchain technology can be considered like another internet revolution, hence in favor of “do not harm” policy: “Governments and regulators should avoid undue restrictions, support a predictable, consistent and simple legal environment and respect the “bottom-up” nature of the technology and its development in a global marketplace. This model is well-recognized as the enlightened regulatory underpinning of the Internet that brought about profound changes to human society”25. Later, CFTC has allowed Bitcoin futures trading at the end of 2017. On the other hand, U.S. Securities and Exchange Commission (SEC) has followed a different approach and review the issue case by case26. In the case The DAO, one of the biggest coin offerings which then became a fraud, SEC issued an investigative report in July 2017 and concluded that DAO token offering is a “security”. SEC has used Howey test27 in order to determine if the token is qualified as “securities”28. Therefore, if a token is classified as “securities” then ICO process must respect current regulations as they apply for IPOs. Due to this reason, ICOs have become more careful in designing the token characteristics and the projects have started publishing disclaimers for the U.S. investors. Some of the ICOs have not allowed U.S. investors participate in token sale.
b. European Union: Each member of the European Union may have a different approach towards the regulation of cryptocurrencies. However, 5th
25 https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-18 26 https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings
27
http://www.legalandcompliance.com/securities-resources/securities-glossary/howey-test-to-determine-if-an-investment-is-a-security/
Laundering Directive helps to establish a European Union-wide regulatory framework for fighting money laundering in virtual currency businesses29. The Directive specifies that providers of exchange services between cryptocurrencies and fiat currencies and wallet providers offering custodial services of private keys may need to be registered or licensed in the European Union countries where they are established.
c. Switzerland: Switzerland has been in favor of an innovation-friendly position towards cryptocurrencies. Since a token is not directly linked to a debt or share, it is not classified as a security and therefore not subject to Swiss securities laws30. However, virtual currency trading and exchange platforms must respect AML/KYC requirements and either become a member of a self-regulatory organization or apply to the Swiss Financial Market Supervisory Authority (FINMA) for a license to operate as a directly supervised financial intermediary31. Generally, Switzerland has a favorable regulatory environment for financial technology organizations, including cryptocurrency-related companies. Therefore, regulatory bodies plan to introduce an innovation-friendly financial technology license32.
d. China: China has become one of the major crypto market. In line with this, token offerings and interest from the investors were closely monitored by the regulators. On September 4, 2017, Chinese authorities issued a statement 29 https://ec.europa.eu/home-affairs/sites/homeaffairs/files/what-we-do/policies/european-agenda- security/20180417_directive-proposal-facilitating-use-information-prevention-detection-investigation-prosecution-criminal-offences_en.pdf 30 https://cryptovalley.swiss/legalities-of-tokenization-in-switzerland-and-the-us/ 31 https://news.bitcoin.com/swiss-regulations-are-driving-icos-away/ 32 https://pestalozzilaw.com/en/news/legal-insights/latest-developments-fintech-regulation-finma-and-swiss-federal-council-reduce-barriers-market-entry/legal_pdf/
prohibiting organizations from launching ICOs and ordering organizations that have completed ICOs to refund their token buyers33. The authorities expressed concerns about financial crimes such as illegal fundraising, illegal issuance of securities, fraud, and pyramid schemes. The statement also prohibits financial institutions and non-bank payment institutions from operating businesses that deal with token fundraising, and, the statement prohibits token exchanges from exchanging fat currency into tokens and facilitating the trading of tokens for cryptocurrencies.
e. Singapore: Cryptocurrencies have been treated as assets instead of securities. However, The Monetary Authority of Singapore (MAS) has also declared that some ICO tokens may be considered securities34. Currently cryptocurrency exchange platforms must comply with the AML/KYC procedures in order to prevent money laundering and financing of terrorist activities. MAS has also issued a regulatory framework called the Proposed Payment Framework35 provide licensing, regulation, and supervision of certain payments and remittance businesses, potentially including cryptocurrency intermediaries. f. United Kingdom: In the United Kingdom (UK), the Financial Conduct Authority
(FCA) considers cryptocurrencies as private currencies. FCA has also proposed a case by case approach and declared that some of the tokens can be considered as securities36. In addition, it admits the lack of jurisdiction when the ICO is based in overseas. Cryptocurrency exchange platforms must comply with the
33 https://www.coindesk.com/chinas-ico-ban-a-full-translation-of-regulator-remarks/
34 https://www.coindesk.com/singapore-central-bank-token-sales-may-be-subject-to-securities-laws/ 35 https://www.bakermckenzie.com/en/insight/publications/2018/01/the-proposed-payment-services-bill
AML/KYC procedures in order to prevent money laundering and financing of terrorist activities. FCA has initiated a discussion in 2017 on distributed ledger technologies (DLT) and stated that the current laws are flexible enough to cover DLT businesses37. However, they also stated that they will keep monitoring the development in DLT market. FCA has recently issued a statement that firms dealing with cryptocurrency derivatives must comply with all current rules in the FCA’s Handbook38.
g. Russia: Russian Central Bank acting as a regulatory body in Russia stated that the regulation of this technology is still in early steps. Therefore, it has not set any rule for ICOs and cryptocurrencies. The Ministry of Finance of the Russian Federation presented a draft of the Digital Assets Regulation Bill which covers rules about defining and establishing a regulatory system for cryptocurrencies, ICOs, crypto mining as well as trading39.
2.6 Growth in ICO Market
Since coin offering mechanism has proved itself a fast and easy way of fundraising, ICO market has continued to grow in 2018. Based on CoinDesk database40 as of August 2018, total ICO volume has been more than USD 14 bn and number of ICOs have exceeded the total coin offerings of the previous years.
37 https://www.fca.org.uk/publications/feedback-statements/fs17-4-distributed-ledger-technology 38 https://www.fca.org.uk/news/statements/cryptocurrency-derivatives
39 “Draft Federal Law “On Digital Financial Assets”
https://www.minfin.ru/ru/document/?id_4=121810&page_id=2104&popup=Y& area_id=4
2014 2015 2016 2017 2018 Total Funding (million
USD) 30 9 256 5,482 14,295 20,072
Number of ICOs 7 7 43 343 460 860
Table 2.2 – Number of ICOs and amount raised
In line with the growing funding size, Top 10 coin offerings of 2018 have raised USD 7.6 bn which is more than all the funding raised in previous years41.
ICO Funding (million USD) Sector Jurisdiction
EOS 4,200 Blockchain Infrastructure Cayman Islands
Telegram 1,700 Messaging Service British Virgin Islands
TaTaTu 575 Blockchain Infrastructure Cayman Islands
Dragon 320 Gaming British Virgin Islands
Huobi 300 Blockchain Infrastructure Singapore
Bankera 151 Financial Services Lithuania
Orbs 118 Blockchain Infrastructure Israel
Envion 100 Blockchain Infrastructure Switzerland
Flashmoni 72 Payment Platform United Kingdom
Neuromation 72 Blockchain Infrastructure Estonia
Total 7,608
Table 2.3 – Top 10 Coin Offerings in 2018 as of August 2018
2.7 Risks and Challenges in ICO Mechanism
Although initial coin offering mechanism opens new opportunities for the ventures in order to raise funds, it also brings certain risks from investor perspective. While this mechanism speeds up the preparation process of blockchain-based ventures for fundraising and also decrease the transaction costs, it might result in following risks for investors.
a. Information Asymmetry: Every investor needs to assess the value of a venture before making any investment. However, especially individual investors, most of the time, are not able to reach necessary information about the venture that venture owners already have (Busenitz et al., 2005). This phenomenon is called information asymmetry. Since individual investors do not have necessary access to information as institutional investors or venture owners, they might invest in the ventures that do not meet their risk and return profile. In order to reduce information asymmetry, investors must be provided with standard information which is required to assess the real value of the investment. In ICO case, however, information asymmetry is one of the biggest risks for investors. Due to lack of standard information disclosure requirements, information about the venture is only limited to whitepaper for investors. In my analysis, some certain information is considered as a signal for investors to assess the venture’s business model and credibility. These signals are information about management team, disclosure on token distribution model, token discount model and token limit (hardcap). My analysis revealed that 46 out of 50 ICOs (92%) have information about their management team (see Section 4.3). Only 33 out of 50 ICOs (66%) have a disclosure on their token distribution model (see Section 4.4). This means that investors have little information about how their
investment will be used during the project. Only 17 out of 50 ICOs (34%) have a disclosure on their token discount model (see Section 4.5). In other words, investors are unable to assess the real value of the project in case of any discount is offered by the project owners. This lack of information, however, causes serious fluctuations in the value of the coin. In addition, only 41 out of 50 ICOs (82%) have a disclosure on their token limit (see Section 4.6). This is another grey area for the investors since the number of tokens offered are not well defined all the time. In a recent paper which is published in 2018 (Zetzsche et al., 2018), it has been found that only 18% of the ICOs provide technical information about the product or service to be offered. About 23% of the projects do not disclose any information about token distribution model.
b. Governance Structure: Corporate Governance Institute describes the governance as the mechanisms, processes and relations by which corporations are controlled and directed. Governance structures identify the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders) and includes the rules and procedures for making decisions in corporate affairs. Corporate governance includes the processes through which corporations’ objectives are set and pursued in the context of the social, regulatory and market environment. Governance mechanisms include monitoring the actions, policies and decisions of corporations and their agents. Corporate governance practices are affected by attempts to align the interests of stakeholders42.
In ICO case, my analysis on selected projects has shown that no project has any governance structure in place. None of the projects have disclosed if they have a Board of Directors, Audit Committee or any other supervisory body. In addition, 46 out of 50 ICOs (92%) in my analysis have information about their management team (see Section 4.3). Unfortunately, none of the whitepapers revealed any information about checks and balances within the project. Therefore, there is no information about the necessary governing bodies within the project that oversees the controlling functions. At the same time, there has been no clear information about the segregation of duties within the project team. Another problematic issue arises in principal-agent problem. The agent (project owner) makes decisions on behalf of the principals (token investors). This means that the agent’s interests are not always in line with the principals43. In addition, most of the projects do not offer equity ownership and voting rights. This structure clearly leaves the investors unprotected in order to claim their rights in case of any wrong-doing or fraud. Similarly, investors have no contractual rights, other than the contents of a non-negotiated agreement, with one-sided terms (such as a broad disclaimer of warranties and limitation on liability, and/or purported token holder obligations to provide indemnification). In conclusion, lack of governance structure (no board of directors, no auditing functions, no clear segregation of duties) leaves investors vulnerable to abuses and scams.
c. Lack of Legal Framework:
While ICOs provide a disruptive way of connecting fund seekers (the ventures) and fund providers (investors), lack of standardization in ICO process and regulatory supervision might result in problems for investors. As almost all the ICOs offer only the right to use a product or service in the future, current regulations may not cover the token holders in case of any dispute. Therefore, there are still many issues to be clarified so that ICOs can gain ground to become a reliable and sustainable funding mechanism.
Since all the token offerings are made via the internet and they attract investors from all over the world, regulatory supervision and law enforcement are limited to national laws (Maume et al., 2018). In addition, each jurisdiction’s approach can be different from each other. While US regulators are looking into the cases when US investors are involved, UK Financial Conduct Authority (FCA) draws attention to its limited power and points out that ICOs might be based overseas44. As it’s described in Section 2.5 in this paper, each jurisdiction follows a different approach in reviewing ICO issues. United States and Switzerland are a few examples of countries that follows “do not harm’ approach for a innovation friendly environment. In the United States, SEC has adopted a “case by case” approach and avoided putting a general framework. On the other hand, countries like China45 and South Korea46 have followed a different approach and banned all the ICOs claiming
44 https://www.fca.org.uk/publication/feedback/fs17-04.pdf pp.15
45 http://static.iris.net.co/dinero/upload/documents/bitcoin-popular-bank-of-china.pdf
https://www.reuters.com/article/us-southkorea-bitcoin/south-korea-bans-raising-money-through-initial-that they result in abuse and scams for the investors and they might be used for financing illegal activities.
Due to lack of dedicated regulatory supervision, investors seem to be virtually unprotected against any possible abuse or scams. In addition, opaque disclaimers in the whitepapers and other disclosures, no contractual rights, other than the contents of a non-negotiated agreement, with one-sided terms (such as a broad disclaimer of warranties and limitation on liability, and/or purported token holder obligations to provide indemnification) as well as unclear information about the jurisdiction where the incorporation of the project is registered are major grey areas for the investors to seek legal protection.
Data Collection Methodology
Starting from 2013, number of ICOs have gradually increased and had a peak in 2017. Along with the token offerings, many different ICO tracking sites have emerged. These sites play an important role for investors since initial coin offerings are unregulated and follows no standard practice. In addition, whitepapers, unfortunately, do not have all the information required in order to assess the project’s valuation.
In this respect, I considered CoinDesk47 as the main source to determine the ICOs issued between 2014 and 2017. CoinDesk is one of the few established and well-respected internet site to track ICOs. After collecting the ICO list from CoinDesk, I searched for whitepapers for these ICOs. I checked related project’s website to obtain whitepapers. In this matter, however, some of the projects have become failed and therefore their websites were
unavailable. At this point, I searched different sources in order to obtain more information about ICOs. icobench48, bitcoin.com49, icoalert50, bitcointalk51, GitHub52, smithandcrown53 and various blockchain forums are used to collect information. All the findings and calculations of my research are compiled into a database which can be accessed via a Google document54.
Based on CoinDesk, 400 ICOs were issued between 2014 and 2017 and raised USD 5.8 bn (see Table 1.1). I reviewed the top 50 ICOs in this period. This group represents 13% of the database. On the other hand, this group raised USD 3 bn and represents 53% of the total fundraising. For my analysis, I reviewed the whitepapers and the websites that I mentioned above to collect information about following subjects:
a. Jurisdiction: This is the place where either the project is run, or the incorporation of the project is registered. As it is elaborated in Section 2.5, jurisdiction is very important for the ventures to design their token as well as token sale process.
b. Sector: The ventures aim to build products and services to bring disruptive approach to new or existing areas. Therefore, the sector is another important subject in my analysis.
c. ICO Management Team: Detailed information about the management is considered an important information about the credibility of the project. The 48 www.icobench.com 49 www.bitcoin.com 50 www.icoalert.com 51 www.bitcointalk.org 52 www.github.comminer 53 www.smithandcrown.com
more information the project discloses the more transparent and reliable it’s considered.
d. Proceedings from Token Sale: The project is expected to provide a clear roadmap on how to use the proceedings from the token sale. This information includes how much will be used for product development, marketing and promotion, administrative tasks and management share.
e. Token Distribution Model: Whitepaper is expected to disclose clearly the allocation of the tokens created. In this disclosure, token distribution among investors, management, miners and other involved parties is disclosed.
f. Token Discount Schedule: Some tokens are offered in pre-sale activities in order to attract more buyers. I reviewed the whitepapers to see if there is a clear explanation for any discount schedule.
g. Hardcap: As it’s elaborated in Section 2.3, any pre-defined limit for token creation is an important factor in after-sale token performance.
h. Return on Investment (ROI): Just like any other investment instrument, ROI is used to measure token performance.
Analysis of the Dataset
4.1 Jurisdiction
It turns out that United States and Switzerland have become favorable jurisdictions. While United States offers a fertile ground for technology start-ups, Switzerland attracts many ventures thanks to its innovation-friendly business atmosphere and judiciary system. On the other hand, Russia and Asia-Pacific region are becoming new attraction centers for the
ventures. One particular ICO, The DAO, has become fraudulent after it has raised USD 152 million. Unfortunately, there was not enough information about this ICO. Therefore, it is labelled as “Not Available”.
Funding (USD mil.) Number of ICOs
United States 1,048 16 Switzerland 796 10 Russia 218 5 Japan 203 2 Singapore 176 4 Not Available 152 1 China 101 2 Estonia 83 3 United Kingdom 77 3 Germany 63 1 France 49 1 Poland 43 1 Bulgaria 23 1 Total 3,031 50
Table 4.1 – Jurisdictional Breakdown of Top 50 ICOs
4.2 Sector
Sectoral distribution of the ICOs revealed that most of the projects focus on developing blockchain technologies that can be used as an infrastructure to disrupt conventional industries such as insurance or logistics.
Funding (USD mil.) Number of ICOs Blockchain Infrastructure 1,535 28 Smart Contracts 577 6 Financial Services 504 10 Consumer Goods 158 1 Payment Platform 157 3 Gaming 53 1 Marketplace 46 1 Total 3,031 50
Table 4.2 – Sectoral Breakdown of Top 50 ICOs
4.3 Management Team
One of the key factors that is considered as a sign for the credibility and transparency of an ICO is to provide detailed information about its management team who runs the project. Based on my findings, majority of the ICOs have published information about their management team. ICOs with disclosed management information are labelled as “Yes”, others are labelled as “No”. One particular ICO, The DAO, has become fraudulent after it has raised USD 152 million. Unfortunately, there was not enough information about this ICO. Therefore, it is labelled as “Not Available”.
Funding (USD mil.) Number of ICOs
Yes 2,759 46
No 119 3
Not Available 152 1
Total 3,031 50
4.4 Token Distribution Model
Another important criterion for credibility is to disclose transparently the allocation of the tokens created. In this disclosure, it’s expected to provide how the tokens are allocated among investors, project team, miners and other parties involved. ICOs disclosing token distribution are labelled as “Yes”, others are labelled as “No”. One particular ICO, The DAO, has become fraudulent after it has raised USD 152 million. Unfortunately, there was not enough information about this ICO. Therefore, it is labelled as “Not Available”.
Funding (USD mil.) Number of ICOs
Yes 2,130 33
No 749 16
Not Available 152 1
Total 3,031 50
Table 4.4 – Top 50 ICOs Based on Token Distribution Information Disclosed
4.5 Token Discount Schedule
When a token is offered during pre-sale with a discount in order to attract more buyers, it’s expected to have information in the whitepaper how much discount will be offered and how long pre-sale period takes place. to see if there is a clear explanation for any discount schedule. ICOs offering discount and providing a clear schedule are labelled as “Yes”, others are labelled as “No”. One particular ICO, The DAO, has become fraudulent after it has raised USD 152 million. Unfortunately, there was not enough information about this ICO. Therefore, it is labelled as “Not Available”.
Funding (USD mil.) Number of ICOs
Yes 1,515 17
No 1,363 32
Not Available 152 1
Total 3,031 50
Table 4.5 – Top 50 ICOs Based on Token Discount Schedule Disclosed
4.6 Hardcap
Pre-defined limit for token creation is an important factor in after-sale token performance. Therefore, it’s perceived that limited number of token in circulation encourages investors. ICOs with hardcap limit are labelled as “Yes”, others are labelled as “No”. One particular ICO, The DAO, has become fraudulent after it has raised USD 152 million. Unfortunately, there was not enough information about this ICO. Therefore, it is labelled as “Not Available”.
Funding (USD mil.) Number of ICOs
Yes 1,927 41
No 951 8
Not Available 152 1
Total 3,031 50
Table 4.6 – Top 50 ICOs Based on Token Discount Schedule Disclosed
4.7 Return on Investment since Offering
I analyzed token price performance since their initial offerings based on the information on Coinist.io55 website which tracks ROI for each token issued. As of July 20th, 2018, total
market value of the Top 50 tokens are around USD 52 bn. Simple average ROI of the selected tokens are 3,270% and weighted average ROI based on their market cap is 136,842%. Market Cap (USD mil.) ROI (Simple Average) ROI (Weighted Average) Blockchain Infrastructure 48,211 5,740% 146,623% Consumer goods 39 -62% -62% Financial Services 604 -13% 20% Gaming 26 -65% -65% Marketplace 18 -46% -46% Payment Platform 1,243 1,000% 2,414% Smart Contracts 1,542 10% 299% 51,682 3,270% 136,842%
Table 4.7 – Top 50 Tokens’ Market Cap and Average ROI
However, Ethereum has become one of the major token among cryptocurrencies and it has reached around USD 47 bn market cap. In addition, its price has risen by 150,902% since its initial offering. Therefore, overall ROI of our selected token portfolio is inflated by Ethereum’s extraordinary performance. Due to this reason, I also analyzed ROI performance of the portfolio by excluding Ethereum. Market cap of the portfolio is then decreased to USD 4.9 bn. In addition, simple ROI average decreased to 257% and weighted average ROI decreased to 1,128%.
Market Cap (USD mil.) ROI (Simple Average) ROI (Weighted Average) Blockchain Infrastructure 1,381 364% 1,451% Consumer goods 39 -62% -62% Financial Services 604 -13% 20% Gaming 26 -65% -65% Marketplace 18 -46% -46% Payment Platform 1,243 1,000% 2,414% Smart Contracts 1,542 10% 299% 4,852 257% 1,128%
Table 4.8 –Market Cap and Average ROI Excluding Ethereum
Conclusion
Blockchain technology has proved to be a disruptive innovation. ICO, at the same time, has emerged as a new way of fundraising mechanism. Since its theoretical and practical framework are continuously changing, it brings many opportunities and also challenges. While its decentralized structure and easy to join for the investors help decrease the cost of fundraising and transaction cost, lack of regulated framework and transparent information disclosure represent challenges in terms of legal, investor rights and tax perspectives. Despite its disruptive effects in connecting fund seekers (the ventures) and fund providers (investors), lack of standardization in ICO process and regulatory supervision, ICOs can result in undesired outcomes from the investors’ perspective. I have concluded that fund seekers should be more transparent and therefore should provide more information in a standard way in order to minimize information asymmetry for the investors. Moreover, policy makers should take action to develop a regulatory supervision mechanism that allows innovative ventures but also imposes clear rules for investor protection.
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